Tag Archives: Hayek

The price of gold may be rising, but gold mining stocks are getting hammeredtoday. And do you know why?

They are still stocks. (What does THAT mean?)

On the heels of yesterday’s late-day price surge, the Market Vectors Gold Miners ETF (GDX), of fell more than 4.5% amid a broader market selloff that sent the Dow dropping more than 300 points and the S&P 500 declining almost 2%.

The dovish minutes from the Federal Reserve’s September policy meeting have gold bugs buzzing. The precious metal touched a two-week high today, amid easing concerns that the Fed is near to raising interest rates, reviving gold as an inflation hedge.

Gold prices rallied to $1,234 a troy ounce, their highest level since Sept. 23, a day after minutes from the Fed’s September policy meeting revealed officials were worried weaker growth in Asia and Europe could curtail U.S. exports. The central bank also highlighted a stronger dollar as a barrier to U.S. inflation climbing toward the Fed’s 2% target, stoking hopes for a sustained period of low interest rates.

The most actively traded contract, for December delivery, was ended the day at $1,225.10 a troy ounce on the Comex division of the New York Mercantile Exchange, up $19.10, or 1.59% after earlier today climbing as high as $1,380.

But while worries regarding a weak economy can lift gold prices they can squeeze gold mining companies. GDX has plunged more than 60% over the past two years with the likes of Barrick Gold (ABX) falling more than 65% during that same time span and Newmont Mining (NEM) falling 59%.

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The above is an article from an “elite” financial publication (Barrons) where the theme is that miners are being hurt/squeezed because they are stocks. I ask my readers how are miners hurt LONG-TERM (the next decade) if the REAL price of gold is rising? Sure miners may have been sold today due to leveraged investors selling to go into cash, but how does that “squeeze” the mining business if gold is risng RELATIVE to input costs like crude oil and commodities? Mining is a spread business. You make money on the spread between input costs and output revenues. Never take what you read on face value.

Miners realtive to gold in the chart above.

Four Boom and Bust Cycles and the Implications for today’s Cycle (Microdocumentary)

This microdocumentary video examines in detail 4 major booms in the last 100 years and explains how monetary policy and interest rate manipulation has led to the inevitable bust:

Corporate treasurers have been driving the bull market in stocks, not retail and institutional investors. The Fed’s Flow of Funds data show that net issuance of corporate equities over the past year through Q3 was minus $274 billion. In other words, buybacks well exceeded gross issues. Nonfinancial corporations registered net buybacks of $419 billion, while the financial sector had net issuance of $119 billion and foreign corporations issued $25 billion, according to the Fed’s data.

The financial sector data include stock issuance by all ETFs, which rose to $174 billion over the latest four-quarter period. Excluding these ETFs, net issuance by financial corporations was minus $55 billion.

The Fed also compiles monthly data for total gross equity issuance. Over the past 12 months through October, corporations raised $152 billion. However, that was overshadowed by buybacks. Data available for the S&P 500 show that they totaled $406 billion over the past four quarters through Q2.

A new blog: www.valueuncovered.com I hope readers learn from this blog. My initial glance shows that this blog focuses on smaller companies. I an impressed with this student’s (aren’t we all students) thoughtful analysis. Don’t forget to always ask of the business has a franchise or not. Does the business generate above average returns on capital. Don’t be deceived by multiples of EV to EBITDA or EBIT. And always do your own independent analysis.

My favorite blog:www.greenbackd.comfor those who invest in asset type investments; net/nets, special situations, and activist stocks.

With the resurgence of Keynesian economic policy as a response to the current crisis, echoes of past debates are being heard—in particular the debate from the 1930s between John Maynard Keynes and Friedrich Hayek. Keynes talked about the “capital stock” of the economy. He argued that by stimulating spending on outputs (consumption goods and services), one can increase productive investment to meet that spending, thus adding to the capital stock and increasing employment.

Hayek accused Keynes of insufficient attention to the nature of capital in production. (By “capital” I mean the physical production structure of the economy, including machinery, buildings, raw materials, and human capital—skills). Hayek pointed out that capital investment does not simply add to production in a general way but rather is embodied in concrete capital items. That is, the productive capital of the economy is not simply an amorphous “stock” of generalized production power; it is an intricate structure of specific interrelated complementary components. Stimulating spending and investment, then, amounts to stimulating specific sections and components of this intricate structure.

The “shape” of production is changed by stimulatory activist spending. And given that in a world of scarcity productive resources are not free, this change comes at the expense of productive effort elsewhere. The pattern of production thus gets out of sync with the pattern of consumption, and eventually this must lead to a collapse. Productive sectors, like dot-com startups or residential housing, become “overbought” (while other sectors develop less), and eventually a “correction” must occur. Add this distortion to the fact that the original stimulus must somehow eventually be paid for, and we have a predictable bust.

These Hayekian criticisms are once again relevant. It is necessary therefore to return to the nature of capital to clarify the issues. Hayek was working from foundations that were developed by his intellectual forebears in the Austrian school of economics. Specifically, it is the Austrian theory of capital that is relevant, and we should begin with that.

The Austrian Theory

The best known Austrian capital theorist was Eugen von Böhm-Bawerk, though his teacher Carl Menger is the one who got the ball rolling, providing the central idea that Böhm-Bawerk elaborated. Böhm-Bawerk produced three volumes dedicated to the study of capital and interest, making the Austrian theory of capital his best-known theoretical contribution. He provided a detailed account of the fundamentals of capitalistic production. Later contributors include Hayek, Ludwig Lachmann, and Israel Kirzner. They added to and enriched Böhm-Bawerk’s account in crucial ways. The legacy we now have is a rich tapestry that accords amazingly well with the nature of production in the digital information age. Some current contributors along these lines include Peter Klein, Nicolai Foss, Howard Baetjer, and me.

The Austrians emphasize that production takes time: The more indirect it is, the more “time” it takes. Production today is much more “roundabout” (Böhm-Bawerk’s term) than older, more rudimentary production processes. Rather than picking fruit in our backyard and eating it, most of us today get it from fruit farms that use complex picking, sorting, and packing machinery to process carefully engineered fruits. Consider the amount of “time” (for example in “people-hours”) involved in setting up and assembling all the pieces of this complex production process from scratch—from before the manufacture of the machines and so on. This gives us some idea of what is meant by production methods that are “roundabout.”

(The scare quotes around time are used because in fact there is no perfectly rigorous way to define the length of a production process in purely physical terms. But, intuitively, what is being asserted is that doing things in a more complicated, specialized way is more difficult; loosely speaking it takes more “time” because it is more “roundabout,” more indirect.)

More Roundabout Production

Through countless self-interested individual production decisions, we have adopted more roundabout methods of production because they are more productive—they add more value—than less roundabout methods. Were this not the case, they would not be deemed worth the sacrifice and effort of the “time” involved—and would be abandoned in favor of more direct production methods. What are at work here are the benefits of specialization—the division of labor to which Adam Smith referred. Modern economies comprise complex, specialized processes in which the many steps necessary to produce any product are connected in a sequentially specific network—some things have to be done before others. There is a time structure to the capital structure.

This intricate time structure is partially organized, partially spontaneous (organic). Every production process is the result of some multi-period plan. Entrepreneurs envision the possibility of providing (new, improved, cheaper) products to consumers whose expenditure on them will be more than sufficient to cover the cost of producing them. In pursuit of this vision the entrepreneur plans to assemble the necessary capital items in a synergistic combination. These capital combinations are structurally composed modules that are the ingredients of the industry-wide or economy-wide capital structure. The latter is the result then of the dynamic interaction of multiple entrepreneurial plans in the marketplace; it is what constitutes the market process. Some plans will prove more successful than others, some will have to be modified to some degree, some will fail. What emerges is a structure that is not planned by anyone in its totality but is the result of many individual actions in the pursuit of profit. It is an unplanned structure that has a logic, a coherence, to it. It was not designed, and could not have been designed, by any human mind or committee of minds. Thinking that it is possible to design such a structure or even to micromanage it with macroeconomic policy is a fatal conceit.

The division of labor reflected by the capital structure is based on a division of knowledge. Within and across firms specialized tasks are accomplished by those who know best how to accomplish them. Such localized, often unconscious, knowledge could not be communicated to or collected by centralized decision-makers. The market process is responsible not only for discovering who should do what and how, but also how to organize it so that those best able to make decisions are motivated to do so. In other words, incentives and knowledge considerations tend to get balanced spontaneously in a way that could not be planned on a grand scale. The boundaries of firms expand and contract, and new forms of organization evolve. This too is part of the capital structure broadly understood.

Division of Knowledge

In addition, the heterogeneous capital goods that make up the cellular capital combinations also reflect the division of knowledge. Capital goods (like specialized machines) are employed because they “know” how to do certain important things; they embody the knowledge of their designers about how to perform the tasks for which they were designed. The entire production structure is thus based on an incredibly intricate extended division of knowledge, such knowledge being spread across its multiple physical and human capital components. Modern production management is more than ever knowledge management, whether involving human beings or machines—the key difference being that the latter can be owned and require no incentives to motivate their production, while the former depend on “relationships” but possess initiative and judgment in a way that machines do not.

The foregoing provides the barest account of the rich legacy of Austrian capital theory, but it should be sufficient to communicate the essential differences between the Austrian view of the economy and that of other schools of thought. For Austrians the whole macroeconomic approach is problematic, involving, as it does, the use of gross aggregrates as targets for policy manipulation—aggregates like the economy’s “capital stock.” For Austrians there is no “capital stock.” Any attempt to aggregate the multitude of diverse capital items involved in production into a single number is bound to result in a meaningless outcome: a number devoid of significance. Similarly the total of investment spending does not reflect in any accurate way the addition to value that can be produced by this “capital stock.” The values of capital goods and of capital combinations, or of the businesses in which they are employed, are determined only as the market process unfolds over time. They are based on the expectations of the entrepreneurs who hire them, and these expectations are diverse and often inconsistent. Not all of them will prove correct—indeed most will be, at least to some degree, proven false. Basing macroeconomic policy on an aggregate of values for assembled capital items as recorded or estimated at one point in time would seem to be a fool’s errand. What do the policymakers know that the entrepreneurs involved in the micro aspects of production do not?

Capital and Employment

The folly is compounded by connecting capital and investment aggregates to total employment under the assumption that stimulating the former will stimulate the latter. Such an assumption ignores the heterogeneity and structural nature of both capital and labor (human capital). Simply boosting expenditure on any kind of production will not guarantee the employment of people without jobs. How else to explain that our current economy is characterized by both sizeable unemployment numbers and job vacancies? Their coexistence is a result of a structural mismatch: The structure (that is, the pattern of skills) of the unemployed does not match those required to be able to work with the specific capital items that are currently unemployed.

In fact the current enduring recession is basically structural in nature. It is the bust of a credit-induced boom-bust cycle, augmented by far-reaching production-distorting regulation. The Austrian theory of the business cycle was developed first by Ludwig von Mises, combining insights from the Austrian theory of capital with the nature of modern central-bank-led monetary policy. The theory was later used, with some differences, by Hayek in his debates with Keynes. Over the years its popularity and acceptance have waxed and waned, but it appears to be highly relevant to our current situation.

Dot-Com and Other Bubbles

The dot-com boom no doubt reflected the advent of a pervasive new technological environment: the arrival and expansion of the digital age. It was a time of great promise and uncertainty and of enhanced risk-taking. Astronomical book values reflected expectations that in total could not be realized. A shakeup was inevitable—and known to be so. It was part of the market process. As the boom expanded, interest rates started to rise, reflecting the increased demand for a limited supply of loanable funds. This, as Hayek would have put it, is the natural brake of the economy, the signal and the incentive to slow down. But the Federal Reserve, not wishing to spoil the party, expanded reserves to keep interest rates low, thus allowing the boom to progress beyond its “natural” life. When the bust came it was bigger than it would have been had the cycle been allowed to run its natural course.

Notice how this story accords with our understanding of the capital structure. The expanding boom reflected entrepreneurs’ expectations of profitably making new capital combinations, only some of which would, in the event, prove to be profitable. But there was no way to know which they were ahead of time. That is why we need markets. Rising interest rates and the passage of time would tend to reveal the less viable ventures and weed them out. Keeping interest rates artificially low prevented this from happening, more so for those projects that were more interest-sensitive—namely, those that had a longer time horizon—or, loosely speaking in terms of our earlier discussion, contained more “time.”

But the dot-com collapse did not really mark the end of the cycle. Much of the extra liquidity was then directed into real estate, specifically into residential housing and into financial assets based on it. This investment channel was wide open as a result of a decades-long, recently intensified congressional and regulatory policy to expand homeownership in America. This is a familiar story that need not be repeated here. The result was an unprecedented expansion of home building and home purchases riding the tsunami wave of home prices. Once again the production structure was pushed out of sync with any kind of sustainable pattern of consumption.

The solution, from this perspective, is to remove the distortions—to allow the market process to “restructure” production. This would mean a sustained period of consolidation in the housing market, not a policy that attempts to revive it (to revive the bubble?) of the kind we are currently witnessing. But then today’s policymakers do not have the benefit of knowing Austrian capital theory.

Article printed from The Freeman | Ideas On Liberty: http://www.thefreemanonline.org

Readers’ Questions

Rather than email a reply, I thought sharing with other readers might be helpful.

A reader writes: Your emphasis on capital compounders raises a question in my mind. WEB (Buffett) famously said that if he was running a million bucks, he could get returns of 50% per year. If you reverse engineer this statement, you have to think he would be investing in the following: small caps, special situations, and catalysts.

I don’t think you can get those kinds of return with capital compounders. Thoughts?

My response: Good point. By the way, any future questions that you have for Warren can be answered here: http://buffettfaq.com/. An organized web-site of all of Buffett’s articles, writings, and speeches organized by subject, source and date–an excellent resource for Buffaholics. Buffett said he could compound a small amount of money at 50% as he mentions below:

Interviewer to Buffett: According to a business week report published in 1999, you were quoted as saying “it’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” First, would you say the same thing today? Second, since that statement infers that you would invest in smaller companies, other than investing in small-caps, what else would you do differently?

Buffett: Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today’s environment because information is easier to access.

You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.

Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.

The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital. For example, I wouldn’t have had to buy issue after issue of different high yield bonds. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.

I know more about business and investing today, but my returns have continued to decline since the 50’s. Money gets to be an anchor on performance. At Berkshire’s size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.

So the Wizard of Omaha agrees with you that returns are probably to be found in small caps where greater mis-pricing on the downside and upside can occur. The problem you have is paying higher taxes on short-term (less than one year and a day) gains and reinvestment risk. Once you sell you have to be able to find other attractive opportunities to redeploy capital. Special situations like liquidations may give you high annualized returns but the positions may only be held for four months until the investment is liquidated.

Investing in a Coca-Cola may give you high risk adjusted returns but not 50% annual returns because of its side and lack of reinvestment opportunities. Unless you find an emerging franchise which is quite difficult, then if you hold Coke for years, you will eventually earn the company’s return on equity.

This writer organizes his investment world into franchises and non-franchises. With non-franchises you are hoping to buy at enough of a discount to asset value and earnings power value to generate attractive returns. A catalyst like a special situation or corporate restructuring may increase the certainty and lessen the time needed to close the gap between price and your estimate of intrinsic value. Often, with non-franchises you do not have time on your side. You must buy at a huge discount to have a chance at 50% returns. These opportunities may be limited to micro-caps with large discounts partially due to illiquidity issues.

By the way, I am a big fan of small cap special situations, and I plan to post my library for readers, but we have to go step-by-step in posting material.

The reasons I want to focus on franchises are the following:

A study of franchises will teach us about investing in growth which is difficult to value.

Studying competitive advantages will hone our skills in business analysis making us better investors.

Knowing that a company is not a franchise is also important, because–then with no competitive advantage–the company must be managed efficiently. We know what to look for in management activity. Diversification would be a warning signal, for example.

Investing in franchises can be quite profitable if bought at the right price. Say 3M (MMM) at $42 back in 2009 was purchased, then you would be receiving today about a 5.5% to 6% dividend with growth in cash flows of 8% to 10% or more, then in a few years you will have a 14% dividend yield leaving out any rise in share price. You compound at a low base while you defer taxes and reinvestment headaches. I think Buffett receives double in dividends each year more than the original purchase price of Washington Post. MMM_35

The biggest gap today in industry and company research is the lack of interest or knowledge in analyzing competitive advantage. Rarely do you ever see an analyst focus on barriers to entry in their valuation work. My hat is off to Morningstar, Inc. because their stock research is geared toward franchises. Many managements have no idea what are structural competitive advantages are. Often, they say their company’s competitive advantage stems from “culture.”

Finally, you want to avoid Hell. Hell is paying a premium for growth for a non-franchise company. Look at Salesforce.com (“CRM”) as an example for today. Full disclosure: I have held short positions in CRM. Thanks again for your question.

Another reader:

First I would like to thank you for the quality work you are doing. I am new to Austrian economics and I would really appreciate if you can walk us on how to get started and how is it different from other Keynesian and mainstream economics. I, also, want to know why Austrian economics would be more valuable to value investors than other schools. I also wonder why we have not been taught about Austrian economics in school and why it’s not taught.

My reply: Oh boy, you are asking for an all-night discussion. I came out of school having studied Keynesian economics (Samuelson’s text-book, http://en.wikipedia.org/wiki/Paul_Samuelson) because that is what American Universities taught back then and still do about economic theory. Imagine studying geography and being told that the world was flat, yet once in the real world ships were circling the globe. What I experienced in real life (raging inflation with high unemployment in the late 1970s) completely contradicted Keynesian theory. Also, the conceit of central planning, having the government intervene, made no sense. How could bureaucrats in Washington, DC allocate resources in Alaska better than an entrepreneur, say, in Alaska? The only economists that predicted the Great Depression and the collapse of the Soviet Union and Eastern Europe BEFORE the events occurred were the Austrians, von Mises and Hayek. So I read, Human Action by von Mises, and became hooked. The world of booms and busts, inflation, deflation and capital formation started to make sense. But I had to UNlearn a lot of nonsense.

As an investor you must understand how man operates in an economy allocating scarce resources to better his condition or lesson his unease. Only Austrians–from what I know–have a coherent theory of the business cycle and the structure of production. But then you may ask, “If Keynesianism is such a repeated failure, then how come it is still prevalent today?” Think of human motivation. If you are a politician, what better cover to weld power than Keynesian theory? Constant intervention to “help” is your guide.

George Soros is the legendary investor who started Quantum Fund in the 1960s and is a multi-billionaire as a result of some winning macro trades. Soros’ prescription for healing broken economies cannot be mistaken for Austrian Economics, but Soros’ analysis of markets as expressed in his books seems to borrow a lot of influence from the Austrian Economists.

Jim Rogers is acknowledged as one of the most successful investors of all time. Making an early start when he was in his twenties, he was able to build a huge fortune with an initial investment of just $600 by the time he was 37. A firm believer in Austrian economics, he advocates investing in China, Uruguay and Mongolia.

Marc Faber was born in Switzerland and received his PhD in Economics from the University of Zurich at age 24. He was Managing Director at Drexel Burnham Lambert from 1978-1990, and continues to reside in Hong Kong. He is famed for his insights into the Asian markets, and his timely warning about market crashes earned him the name of Dr.Doom. In 1987 he warned his clients to cash out before Black Monday hit Wall Street. In 1990 he predicted the bursting of the Japanese bubble. In 1993 he anticipated the collapse of U.S. gaming stocks and foretold the Asia Pacific Crisis of 1997-98. A contrarian at heart, his credo has always been: “Follow the course opposite to custom and you will almost always be right.”

James Grant, a newsletter writer who publishes “Grant’s Interest Rate Observer” is also a follower of Austrian Economics. He is a “Graham & Dodder” too. Go to www.grantspub.com

Ron Paul, a Republican Congressman for the Texas State, is also a believer of Austrian Economics.

Interestingly enough, Howard Buffett, the father of Warren Buffett is also an Austrian Economics follower. His son, Warren, however, seems to be more inclined to the Keynesian method of healing broken economies as opposed to the strict and rigid ones espoused by Austrian economists. Warren Buffett did acknowledge in a recent TV interview that one will have a hard time finding a paper based currency that appreciates in value over time. (All fiat currencies have been debased to worthlessness.)

And if you want to interact with professors you can go to the Mises Academy here: http://academy.mises.org/. Don’t go by what I say, but by what YOU think after delving into the material. Does it make sense? Forget political labels of Right-wing, Democrat, Liberal, and Conservative; think of how the world works. I hope that helps partially answer your question.

The same reader asks another question:

I have another question related to Bruce Greenwald book, Competition Demystified. In his book he mentioned that if the company has no competitive advantage then strategy is irrelevant and the course of action should be efficiency. However, following this argument, investors would have avoided many companies during the journey to become industry dominant player.

Correct me if mistaken, but I don’t think you have read the entire book yet. Greenwald will talk about entrant strategies from the point of view of the incumbent (crush an entrant) to an entrant (how to gain a foothold profitably against an incumbent). Greenwald will also talk about cooperation between incumbents.

If you want a more detailed description of emerging franchises–though I suggest you read it after Greenwald’s book–read Hidden Champions of the 21st Century by Hermann Simon.

I can promise you that one of the reasons for Buffett’s success is his amazing understanding of competitive advantages in his investments. As a business person understanding strategy is critical.

Here is a question. You own a chain of very profitable movie theaters within a 150 mile radius of a major city. These theatres are spread about 5 to 20 miles from each other and are nicely profitable. You have economies of scale in hiring, securing first-run films, buying condiments, etc. You awake one morning to find that another large regional theater chain from 800 miles away wants to open a theatre near one of your 29 theatres. What response might you offer to send a strong message not to enter this market? A paragraph is enough.